The legendary investor Benjamin Graham once analogized the stock market to a manic-depressive character he called Mr. Market. Sometimes Mr. Market is ebullient, and no price is too high for his stocks. At other times, he is gripped by despair and will offer you his goods at incredible discounts. As investors, our job is to gauge how Mr. Market is feeling and react accordingly. One simple way to assess Mr. Market’s mood is by using the great investor Howard Marks’ market conditions score-card.*

Mark’s scorecard is divided into two sections. On the left side are market conditions that tend to associate with overvalued and risky markets for investors. And on the right side are conditions that commonly correlate with undervaluation and good investment opportunities. Here is what that scorecard would show today based on my best estimates:

As you can see, a substantial majority of market conditions today land on the risky side of the table: Lenders are eager, capital is plentiful, credit spreads are narrow, recent performance is strong, and asset prices are high which means that prospective returns are low. Even more telling, there is nothing checked in the opportunity column. As a whole, this chart indicates that investors may be manically optimistic and thus irresponsibly dismissive of risk. As Howard Marks likes to put it, “The riskiest thing is thinking there is no risk… You want to take risk when others are fleeing from it, not when they’re competing with you to do so.”*

But before we get too carried away with worry, keep in mind that this chart does not necessarily mean there is going to be a crash. The fact is that had we performed this same exercise over the past few years, it would have produced similar results. Meanwhile, the stock market generated strong returns.

Where it can be helpful is in calibrating your appetite for additional risk. For instance, if you are considering investing in a cyclical business, or thinking about whether to take profits in the hot technology stock you bought a few years ago; Mr. Mark’s scorecard can help to determine if you should be actively seeking or avoiding additional risk.

Thought for the Week:

“For the last nine years, central banks drove interest rates to nil and pumped money into the system creating favorable carries and abundant cash… That era is ending… Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered rather than increased… Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

– Ray Dalio,
Central Bank Reversals Signal The End of One Era
and The Beginning of Another

** I have slightly modified Mark’s table in the interest of brevity.

** Marks, Howard. The most important thing: uncommon sense for the thoughtful investor. New York: Columbia U Press, 2011. Print.

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